I have an op-ed on Bloomberg today, arguing that inflation is a much bigger problem in China than people realize. You can read it here. I’ll be posting the entire article tomorrow, but today, I want to respond to all the questions I’m getting about last night’s announcement that China’s central bank will be raising interest rates, by 25 basis points (0.25%) for the first time in nearly three years. What does this mean for growth and inflation?

I have a very unconventional take on this development.

The standard assumption is that a hike in interest rates is a tightening measure, because when the price of borrowing money rises, demand for it should fall, reining in economic activity. However, as I see it, in the prevailing interest rate range, both supply and demand for lending in China in relatively inelastic — that is, a modest 0.25% increase won’t have much effect on people’s willingness to borrow, or banks willingness to lend. Given the boom environment in China today, most borrowers either think they’re going to double their money, or (in the case of mortgage borrowers) are desperate to keep up with skyrocketing asset prices. In my experience working in private equity here, I’ve known borrowers to shop around aggressively for the cheapest interest rate, but at the end of the day, regardless of what interest rate they’ll get, they’re going to take the money. Maybe that might change if you up the rate by 5 or 10%, but 0.25% barely registers. (The evidence for this, besides my own experience, is that Chinese borrowers who either don’t have access or can’t borrow any more from banks are regularly willing to pay rates near 20% in the informal lending market.)

On the other side of the equation, banks have a guaranteed spread of nearly 4% between the regulated deposit rate (just above 2%) and the minimum lending rate (6%). To the extent they can, they try to direct loans toward state-owned enterprises (SOEs) that they see as virtually risk-free. From their point of view, it’s arbitrage, and they are going to lend every yuan they can, constrained only by their lending quota and reserve requirement. If the deposit rate increases by 25 basis points, and banks can’t raise their lending rates, their spread will narrow and so will their profits, but they still have every incentive to keep lending. But since borrower demand is also inelastic, they probably can raise their rates without seeing any fall-off in lending.

The main constraint on bank lending in China — and the effective tool China’s central bank has for tightening — is the reserve requirement ratio (RRR). Last year, as I note in my Bloomberg article, Chinese banks drew down on their actual reserves from 21% to around 17%. At the same time, China’s central bank has been raising the RRR to just over 17% for large banks, a bit lower for smaller ones. For the first time in living memory, the banking system as a whole has run out of excess reserves and is bumping up against its reserve requirement. The Chinese interbank lending rate has shot up, and banks have been scrambling for deposits that would allow them to keep lending.

When the regulated deposit rate is lower than CPI — as it has been for several months now — people with their money in bank accounts are losing buying power. They start withdrawing money from banks and either spending it or (more likely) stashing it in non-fixed return forms of savings like real estate or gold. By squeezing deposits out of the banking system, ultra-low interest rates in China have reinforced the reserve constraint on bank lending — acting, in effect, as a tightening measure.

Raising regulated interest rates actually loosens this constraint. It’s bizarre, I know, and entirely contradicts everything we normally think about the effect of interest rates on lending. And I’m not saying this is how China’s central bankers are even looking at the issue. But I believe the dynamics I describe are accurate.

Viewed in this light, China’s interest rate hike isn’t really a policy to actively head off inflation, it’s an involuntary response to inflation. As CPI rises, the gap between CPI and the regulated deposit rate widens, squeezing more deposits out of the banking system, putting more pressure on banks to rein in lending. At some point, in order for the banks to continue lending, you need to raise the deposit rate, otherwise their reserve constraints will force them to stop. (Of course, Chinese officials could also lower the RRR, but such an overt loosening measure would be a much harder sell in the face of rising inflation). The point is that inflation is driving interest rates, not the other way around.

So besides relieving pressure on banks, and keeping the money flowing, what other effect will the interest rate hike have? Well, one thing is that it will increase interest expenses, and reduce profits, across a wide swath of the Chinese economy. Even when Chinese companies have fixed-rate loans, they’re effectively floating-rate, because the terms are short (usually a year), and the interest rate hike will kick in when they roll over. This bottom-line impact, particularly on SOEs, is probably why Chinese officials were so reluctant to raise interest rates for so long, and why they’ll probably take a lot of heat for it now. Even if higher rates are (perversely) a loosening measure, to most Chinese companies it will still feel like a tightening measure, even as they keep borrowing.

(By the way, one last thought. I mentioned Chinese borrowers regularly being willing to pay 20% rates in the informal credit market. The last time I remember people willingly paying such rates to fund business expansion was during the Dot-Com Bubble, when people were financing start-ups on their credit cards. It’s a good illustration of the boom mentality prevalent in China right now).

Interesting comments–I’m sure that your challenge to the economic orthodoxy regarding interest rates/loan demand will be ignored, but to me it makes sense. I have thought for a long time that we would be much better off with higher interest rates in the US for the reasons you state–loan demand is inelastic; lowering interest rates doesn’t get people to borrow money, expectations of improvement in conditions/an increase in asset prices does. Keeping interest rates at zero just tells people that things aren’t getting any better–and that they can’t expect any return from their savings.

None of the degreed and heavily-credentialled economists will agree with this line of reasoning, but it is probably true nonetheless. :>)

A good point you raise. A journalist in Beijing asked me the same question earlier today. I’m going to post a discussion of this in the next day or so. (BTW, for the banking system as a whole, the loan-to-deposit ratio is closer to 66-7%, and has been fairly stable for most the year. The larger listed banks have always tended to have a stronger reserve position than average, and tend to be the lenders in the interbank market).

Nice post, as is the Bberg opinion piece. It highlights the difficulties facing policy makers. Sort of: China, meet the Economic Trilemma. Put you finger in the dike wherever you wish, the water will still find its’ way in.

Well it’s a quality problem to have: just raise the interest rate. The economy is obviously overheating, and has been for a few years now. You’ll notice the recent Yuan ‘loosening’ would also slow down businesses (eg. make Chinese exports more expensive). China loosened the Yuan (letting it appreciate slightly) to cool down the economy, not for any whining on America’s part.

Letting the Yuan appreciate and raising the interest rates seem to go hand in hand.

As for Chinese banks bumping up against the reserve requirement, wouldn’t you assume they were doing that anyway? That’s why the requirement is there. They’re trying to maximize profit by lending out as much money as they are legally (ahem) allowed.

As a side note on domestic consumption, I have a perspective on your comment about invest in assets as opposed to consumables? A recent trip to the US with my Chinese associates crystalized an insight that I think is relevant to the consumption problem. You touched on this in a post a few months ago, talking about the restructuring needed to move towards an efficient consumer distribution system in China.

I would expand on that by saying that it is pretty obvious if you live in China why people don’t consume more. Who wants to buy the junk they sell? Chinese get the factory seconds, the old styles, the poor quality products that are left over, having failed the quality controls of the western retailers.

Furthermore, you go to a retailer in China, and you have to put up with poor service, lousy return policies, and a general impression that the retailer is more concerned with following archane policies and making sure you don’t shoplift. Floor people are untrained and certainly not empowered to take care of the customer.

Of course, you can instead go to a street vendor and spend 25 minutes haggling over the price of an appliance or a set of CDs, etc. And then when you get it home, it falls apart after a couple of weeks. My colleague went through 4 flat irons before he got one that would not leak all over his shirts. What’s to go wrong with a flat iron?

My Chinese colleagues went crazy in the US buying all kinds of things, many of which we made in China. They insist that these goods are cheaper in the US and better quality.

In Beijing, side by side are two shopping areas: The Yashou market and the Villlage. Yashou is very much like the Silk market, with vendors tugging at your elbow to buy North Face jackets and Nike shoes (all knockoffs, of course). Conversely, the Village houses the big name consumer stores, Apple, Addidas, Nike, etc. I find it humorous that the westerners shop at Yashou while the local mainlanders shop at the Village.

We often talk about lack of a social safety net and cultural patterns of thrift. But I think the issue of trust, reputation, product quality, retailer service and the consumer experience is just as valid an issue. Just step back and look at the mainland consumer’s alternatives and it’s pretty easy to see why people don’t regularly buy discretionary items.

The secretary that makes 1800 rmb per month would rather save 500 rmb a month for 4 months and then go buy a real Coach purse than spending 300 rmb on some knock off or off brand item that will fall apart in 2 months.

As far as I know, and I do read a lot, no one is talking about this issue. There is some vague discussion about improving the service sector part of the economy in the 5 year plan. But no one seems to talk about the real issues in distribution and retailing on the mainlland. I would love for you to do a post on this issue.

Enjoyable reading and a completely new as well as unconventional perspective on the effect of interest rates.
My thought is that if the authorities were indeed seriously trying to cool the economy , they could have chosen to increase the reserve requirements . The fact that they didn’t is probably an indication that over-heating is not as big a concern as is made out to be . Hiigh levels of growth are indeed a necessity in an economy where large sections of the population face poverty . Hence the delicate balancing act between not letting inflation get out of control on the hand and allowing lending to support much needed growth on the other.